YUAN'S PEG A PROBLEM FOR STRONG EURO

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<strong>JANE FOLEY<br />RESEARCH DIRECTOR, FOREX.COM<br /></strong>CURRENCY flexibility in Asia is a contentious issue, so the appearance of US President Barack Obama and US Treasury secretary Tim Geithner at the Asia-Pacific Economic Cooperation (Apec) meetings last week immediately brought the topic back into the spotlight. Geithner made the most of the opportunity to stress the importance of flexible currency policies for countries. <br /><br />Although many commentators see a change in Chinese policy &ndash; the yuan is currently pegged to the dollar &ndash; as unlikely until the second half of next year at the earliest, it appears increasingly inevitable that some adjustment to the exchange rate will take place over the next year or so. <br /><br />Pressure on China to do this is coming from several areas, most notably the US. China&rsquo;s policy of keeping the value of the yuan artificially low has for a long time been associated with a build up of global imbalances, which are visible in China&rsquo;s own huge foreign exchange reserves and in the US&rsquo;s current account deficit. <br />Economists and politicians have for a long time being urging creditor nations such as China to do more to address these imbalances. <br /><br />Normally this would be addressed by an increase in savings in debtor nations like the US and a rise in consumption in countries with huge current account surpluses. And, to some extent, this has been happening. Americans are putting more money away to protect themselves from inflation and to improve their financial standing in the wake of the crisis. And a government stimulus package in China has had some effect on consumption. <br /><br />There is a growing concern that bubbles are now forming in some Asian asset prices, which is stoking fears that policy tightening in China and other countries in the region is imminent. <br /><br /><strong>DEFLATING BUBBLES<br /></strong>But while policy tightening may have some effect on deflating these asset bubbles &ndash; the World Bank has advised that it is necessary &ndash; many commentators argue that the most appropriate first step towards tightening would be a breaking of dollar pegs. This would promote domestic consumption by encouraging imports and would also help to drive down global imbalances.<br /><br />However, much as US manufacturers and Eurozone policymakers might like to see the yuan adjusted sooner rather than later, China cannot rush the transition to a fully convertible exchange rate. If it were to do so, it would risk large capital outflows and could also undermine its banking system, two things no country can afford to do. <br /><br />But if Beijing does allow the yuan to rise against the dollar in the near future, then it will be the Eurozone that will benefit most from this move towards greater flexibility. An appreciation in the yuan will relieve pressure on the real effective exchanges rates of Japan and the Eurozone, which are both currently bearing the brunt of the weakening dollar. <br /><br />As the euro rises against the dollar, the Chinese peg means that the single currency is also, unfortunately for exporters in the single currency region, rising against the yuan. The Eurozone, which imports many goods from Asia, is therefore suffering from a punitive exchange rate that is expected to hinder its economic recovery. <br /><br />It&rsquo;s not just China that&rsquo;s the problem for the Euro area, either. Other Asian countries such as South Korea, which have flexible exchange rates, have recently intervened to stop their currencies becoming too strong against the greenback and also to prevent them losing their competitive advantage over China. The net result has been that the euro has appreciated 25 per cent against the South Korean won. <br /><br />Given that the US is the region&rsquo;s second largest trading partner after the UK, the weakening dollar would always have been a painful experience for the Eurozone whatever China&rsquo;s currency policy. However, there is no doubt that the yuan&rsquo;s peg to the dollar has made it even worse in recent weeks. <br /><br />Added together, China, Hong Kong and South Korea account for over 11 per cent of the weighting of the euro against a basket of its trading partners. This rate&nbsp; is already edging back up towards its December 2008 record high as the dollar has fallen, putting the Eurozone at a disadvantage to not only the US, but also countries that have pegged their currencies to the dollar.<br /><br />It is clear that any revaluation of the yuan will offset some of the upward pressure on the euro&rsquo;s exchange rate that has been exerted by a falling dollar. <br />Research EMEA@forex.com